The Federal Reserve Board Monday unveiled rule changes intended to curb deceptive mortgage lending practices, most of which will take effect in October 2009 and apply to all lenders whether they are supervised at the state or federal level.
Although lenders have drastically cut back on the subprime loans targeted by the most restrictive of the new rules, the rules could also apply to some jumbo mortgages and alt-A loans that carry high interest rates and hamper the recovery of lending to borrowers with blemished credit.
The most stringent new rules put forward by the Fed apply only to high-interest-rate loans. They include restrictions on prepayment penalties and requirements that lenders set up escrow accounts to collect payments for property taxes and homeowners’ insurance on first-lien loans. The escrow requirement won’t be phased in until 2010 to allow lenders time to adapt.
Lenders making "higher priced" mortgage loans — a category that covers some but not all "subprime" loans — will also be required to assess a borrower’s ability to repay the loan from their income and assets other than the home itself. Borrowers seeking these loans will be required to verify their income and assets.
The changes to Regulation Z, which spells out enforcement of the Truth in Lending Act, also include several measures that will apply to all mortgage loans. There are new prohibitions against coercing appraisers to inflate a home’s value and a requirement that lenders provide a good faith estimate of loan costs within three days after a consumer applies for a mortgage. The Fed is also banning certain deceptive or misleading advertising practices such hiding the fact that a rate or loan payment can change.
With states like New York and North Carolina already adopting similar or more stringent measures, the Fed’s actions were largely welcomed by the lending industry, which sees a patchwork of conflicting regulations at the state and local level as cost prohibitive.
"I think nationwide, we’ve seen a muddle around the regulation of predatory lending," said David Hamermesh, research director for consumer lending for the consulting firm TowerGroup. While the Fed’s rules may not stop states and cities from putting their own rules in place, "Anything that can clear up the patchwork of regulation that the absence of federal guidance has created is a good thing."
At the Mortgage Bankers Association, "Our preliminary assessment is that it’s a tough rule, but one which to a large extant is codifying what’s already happening in the marketplace," said Steve O’Connor, senior vice president of government affairs for the MBA.
Consumer groups also welcomed the changes as a step in the right direction.
"I think that the final fed rules are clearly a step forward to returning lenders to common sense business practices in the subprime market," said Paul Leonard of the Center for Responsible Lending. "While certainly a number of specific provisions fall short of what states are already doing, we think they’ve taken some key steps forward."
The Fed withdrew a proposal to require that mortgage brokers enter into written agreements with borrowers before collecting yield spread premiums. Yield spread premiums are rebates paid by lenders when loans carry higher interest rates than borrowers might otherwise qualify for. While many borrowers choose loans that come with rebates to help them pay their closing costs, critics say mortgage brokers may pocket yield spread premiums without the consumer’s knowledge.
The National Association of Mortgage Brokers has argued that loans originated by bank loan officers carry similar fees. Although the fees are charged when the loans are sold into the secondary market, they are ultimately born by the consumer, but not disclosed to them, the group argues.
The group’s president, Marc Savitt, said that if yield spread premiums are singled out, "It doesn’t really do anything to help the consumer shop — it only causes more confusion. It’s better if everybody discloses (the fee) or nobody discloses it. Consumers must be able to compare apples to apples."
The Fed said it backed down from its proposal for yield spread premiums because consumer testing had shown it could prove confusing. But the Fed said it will continue to consider alternative approaches to regulating the rebates to consumers.
As part of proposed changes to the Real Estate Settlement Procedures Act, or RESPA, the Department of Housing and Urban Development has proposed that yield spread premiums be automatically credited against closing costs in the good faith estimate provided to borrowers (see story).
The Mortgage Bankers Association hopes that when the Fed revisits the issue of yield spread premiums, it will coordinate with HUD, O’Connor said.
"We think it’s important to have meaningful disclosure of broker compensation," O’Connor said. "It’s better to get it right than to try to do it quickly, particularly in light of what HUD is trying to do with its RESPA proposal."
The Center for Responsible Lending will continue to push for an outright ban on charging yield spread premiums on subprime loans, which provide "perverse incentives to brokers to sell higher cost loans," Leonard said. North Carolina is implementing such a ban, and other states are expected to follow suit, he said.
The Fed "did the right thing in scrapping a proposal that was not likely to work," Leonard said, and would only have provided "a false sense security in that area."
Another significant change from the Regulation Z amendments as originally proposed in December was the definition of a higher-priced loan.
The Fed had proposed two definitions, one for first-lien loans and another for seconds. First-lien loans were to be defined as higher-priced if their annual percentage rate (APR) exceeded by 3 percent or more the yield on comparable Treasury notes. For second loans, the threshold was to be 5 percent.
Citing technical problems with implementing that definition, the Fed said it will instead tie the threshold to actual mortgage rates as surveyed by Freddie Mac. First loans will be defined as higher-priced if they carry an annual percentage rate 1.5 percentage points or more above the survey of mortgage rates. Second loans carrying rates 3.5 percentage points above surveyed rates will be subjected to the additional restrictions being introduced for higher-cost loans.
The definition will capture "virtually all loans" in the subprime market but "generally exclude" prime mortgages, the Fed said.
At the height of the credit crunch, the "spread" on jumbo loans approached the 1.5 percent difference stipulated in the rules as triggering the tougher requirements. But since the Bush administration and Congress gave Fannie Mae and Freddie Mac additional leeway to purchase or guarantee loans up to $729,750, spreads on jumbo loans have fallen.
The Fed’s definition "seems like a reasonable limit that allows for conforming lending, jumbo lending, and alt-A lending," Hamermesh said. "This focuses on subprime, and puts some protections for consumers in place."
The Mortgage Bankers Association issued a statement saying the group is "carefully reviewing" the definition of higher-cost loans, saying the group "strongly believes that it is essential for credit not to be unduly restricted."
Leonard said that from the Center for Responsible Lending’s perspective, the larger issue is that so called "non-traditional" or "exotic" interest-only and payment-option adjustable rate mortgages (ARMs) continue to be exempt from the tougher standards.
Those restrictions include a ban on any prepayment penalty if the loan payment can change in the initial four years. For other higher-priced loans, a prepayment penalty period cannot last for more than two years. Those restrictions are "substantially more restrictive" than originally proposed in December, the Fed said.
But Leonard said the restrictions on prepayment penalties "leave much to be desired," because they still allow lenders to penalize borrowers who refinance fixed-rate subprime loans within two years and to assess prepayment penalties on subprime ARMs refinanced after four years.
"We would have preferred an outright ban" on prepayment penalties for subprime loans, which 10 states have already enacted, Leonard said. The House has passed legislation authored by Barney Frank, D-Mass., HR 3915, The Mortgage Reform and Anti-Predatory Lending Act of 2007, which would not only eliminate prepayment penalties on subprime loans, but limit their use with prime loans (see story).
That’s a view shared by Sheila Bair, chairwoman of the Federal Deposit Insurance Corp., who in an April 7 letter to Fed Chair Ben Bernanke recommended that the Fed consider an outright ban of prepayment penalties on higher-cost loans. Prepayment penalties, Bair said, can leave borrowers with the difficult choice of either paying a large penalty to refinance or "continuing with a loan they cannot afford and, by doing so, stripping their home of equity or losing their home through foreclosure."
O’Connor said the Fed’s new restrictions on prepayment penalties — which are designed to protect investors who finance ARM loans — are largely moot at the moment. That’s because the loans they would apply to — 2/28 and 3/27 hybrid ARM mortgages — have largely disappeared from the market. But when the secondary loan market recovers, the elimination of prepayment penalties could limit a resurgence in hybrid ARM lending, O’Connor said.
For now, because of the lack of subprime loans, "the total impact on the mortgage market as a whole is not that big," said TowerGroup’s Hamermesh. "A lot of the loans that are covered aren’t going to be available to consumers" for some time.
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